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| | May 10, 2006
The Commodities Bull...How Long?
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| | HOW LONG WILL IT LAST?
One of the questions I am most often being asked today and recently is "How long will these rising commodities prices last"? And my answer is; "much longer than you might think"... This, for those who don't believe the bull is real, is a serious conundrum. For the rest of us some vital history might help provide a partial answer.
The last time we saw a bull market in commodities of any similar proportion was in the late 60's and 70's culminating with the Ronald Reagan election in November of 1980. This period, as some of you may recall, was the "guns and butter' days of Vietnam and the dollar/gold crises of 1971 when the then nemesis of US policy Charles DeGaulle, said "no more paper, give me the hard stuff." Nixon showed him a thing or two, he closed the window on gold and the "almighty dollar" started its nose dive reaching its nadir during the Jimmy Carter days of cardigan sweaters; $37.00 ppb oil, $57.00 per ounce silver, $850 per ounce gold and 20+ percent interest rates. Jimmy, in his own inimitable style, called this America's "malaise" while the rest of us lined up to buy our gas and curse his Cheshire cat grin. (Don't get me started on this phony, I could go on for pages.) Anyway, my point is that the last go-round for high commodity prices was due almost entirely to a monetary crises sparked by a monetary inflation causing price inflation. The supply vs. demand factor was only present at the gas pump. The politicians, not wanting boobus americanus to be "price gouged" passed a wind-fall profits tax on oil companies and slapped a price control on gasoline all of which resulted in longer lines, no price savings and lots of "off road rage" and curb side fisticuffs. Ahhhhhhh the good ol' days of democrats in power everywhere.
But this time it is different! Yes, yes, I know that to use this phrase is supposed to show one's ignorance or immaturity...but I can prove its accuracy with just two words...China, India. In the period discussed above China was still in the process of being starved to death by Maoist communist policies while India was not much better off due to Gandhi/Nehru socialism of a more benign nature. Eastern Europe, including Mother Russia, was queuing up to buy anything which was at the end of the line. No surpluses of anything in the Soviet Block except western liberals at the ticket counters of Aeroflot trying to book passage back to their capitalist comfort zones to explain the blessings of Marxism to the ignorant.
Let us now jump to the present and the commodities bull which began to charge in 2001. Gold recently touched above $700 and copper hit an all time high of $ 8,000 a ton. Yet, despite this magnificent performance, there are still those who think that this amazing rise is just a flash in the pan. My personal feeling is that the majority of the bears are investors who were burned by the 90's tech market (which is just about everybody). Either they dismiss the numbers as an un-mitigated rise to un-justified prices, or they have simply paid so little attention to these markets that they are scratching their heads and fishing for tips. The best the bears can do is say "it's too late" to get on board, or make untoward comparisons between the current situation and what happened in leading up to the Reagan election. Well my friends, they are dead wrong and about to miss a truly historic opportunity. The commodities boom is just beginning. When the dust settles 5-15 years from now we could see gold as high as $2,000 an ounce. When that happens we will be smiling back at all the bears---no need to say 'I told you so.' In the following paragraphs, I will tell you why gold and commodities are here to stay. Truly, this time is different.
The dollar must fall
As you may or may not be aware, there is a direct relationship between the price of gold and the supply of fiat currency or money--particularly in the case of the U.S. dollar. As the dollar weakens, gold becomes stronger because while gold is inherently valuable, paper currency is based on the trustworthiness of a government to live up to its promises, and we all know the value of a government promise. Needless to say devaluation of the dollar = a rise in the price of gold. You can trust gold; it won't lie or make more of itself. It will always be yellow, scarce, and immensely attractive. The dollar, on the other hand, has no inherent value, can be printed by the billions, and is based on the U.S. government's ability to fulfill obligations---which is wearing thin.
The only reason why the dollar hasn't already seen a significant downturn is because countries like China and Japan have such a vested interest in maintaining the value in the currency. But do not be fooled, the future of the USD is in Eastern, not Western, hands. The U.S. government, in its infinite meddling, has managed only to delay the inevitable, and piss away the power to put punch back in the paper. Say that ten times fast.
If officials in the Central Bank of China decided to start using their enormous supplies of USD to buy the west's gold, they would quickly become the most dominant banking/currency power on earth. If China demanded delivery of that gold, then they would achieve a massive victory over the west (though it be symbolic). Call it 'the last laugh' for the Opium Wars. Recently the Chinese lifted many of the restrictions on its currency allowing foreign investment to flow more freely in and out of China. Could they be positioning the Renmimbi for this sort of change? I don't know, but someday China will realize how easy it could be, and the gold-hating economists of the West will be left standing with their pants down and their hands out. Very uncivilized.
Meanwhile the U.S. government continues to 'print' money in unprecedented amounts while simultaneously voting to dip its great greasy hand into the collective piggy bank (aka the social security fund). And, as if this weren't enough, the Fed, as of March 06,' will no longer provide the M-3 report without so much as a 'peep' from Congress. Don't know what the M-3 is? It's only the most obvious reporting item where the market manipulations of the PPT (plunge/crash protection team) show up. The government 'prints' new money electronically and the PPT uses that money to purchase securities in order to stabilize or facilitate the buying of certain markets. This is how new money gets into circulation (thus the M-3 provides our best reference for how much new money is being created i.e. 'inflation'). There could be many reasons for this sort of incognito activity, but our favorite two are these---One, the government foresees some sort of impending crisis which will require a hyper-inflationary bail out, and two, the markets are much closer to a serious downturn than anyone expects. Hiding the M-3 numbers is, above all else, an indication of the intention to manipulate markets on a massive scale. Why hide it? The Fed doesn't want inflation expectations to have an adverse effect on the U.S. economy. It is only a matter of time before investors realize what is happening here, and when they do the 'gold fever' will hit like Tiger Woods' driver. Investor's will buy gold for dollars in an effort to hedge inflation.
Inflation fear, however, has not yet struck, and is not the driving force behind the current commodities markets, but when it does it will drive investors into a feeding frenzy. Today's prices are a result of an increase in global productivity, and are 'bargain basement' compared to what they will be when the sharks get the smell of blood, or should I say ink and paper. But the gold price has much further to rise, and we have plenty of time before these fears materialize and the markets wake up to what is happening, although the first rumblings can be felt. How do we know that most investors are unaware? Good question.
For some time now we have talked about what we in investing circles refer to as a "reverse cantango." This means that prices in the futures market are lower than current cash market prices. For example, gold for November delivery costs less than if you were to go out and buy it today on the spot market. This reflects a pervading market belief that gold is currently over valued, but more importantly, it is an indication that the markets don't know why the price is moving. Most investors think it is a fluke, an apparition. If they thought otherwise, then this 'reverse cantango' would not exist. Prices in the futures market are supposed to reflect the core price of the commodity itself plus the cost of "carrying" (interest, warehousing, insurance etc.) until the specified date.
Global Productivity
As you read what follows, keep one thought in mind...productivity trumps everything as long as it stays ahead of inflation.
The current prices of commodities, as previously stated, are not a product of some sort of inflationary concern, false expectation, or over enthusiastic speculation, they are a result of an increase in over-all global productivity and the need for more raw materials to facilitate continued growth. Further demand comes from the luxury wants of a new contingent of middle and upper class consumers created by Eastern industrialization.
India, who's GDP, has increased by more than 6% annually since the 90's, accounts for approximately 23% of consumer gold sales. This figure is up almost 25% from 04' which is a remarkable indication of the massive expansion of the middle/upper class which has occurred as a result of the booming economy. The purchase of gold in India is a microcosm of what is happening all over the East as living standards rise to match the inflow of wealth. Gold happens to be important in India because of its use in religious ceremonies and marriages, but this kind of luxury buying is happening all over, and is affecting the demand of commodities in general. A little known fact in this regard is that the Chinese government now allows private gold ownership. This has spawned the creation of the Shanghai Gold Exchange which is fast challenging Hong Kong as the Orients major gold market place. In a country where everyone works to catch-up with 70 plus years of nothing to buy, everything is dear and commodities of every type are winners.
To put it another way, air conditioner sales of the largest supplier in China are on track to rise by 12% this year (air conditioners are considered a 'luxury item' in China). They produce 2.5 million units a year, and require vast amounts of copper---that is just one company in one sector... Copper is used in just about every electronic device, in plumbing, cars, electro-magnets, fixtures, any sort of refrigeration technology, art (The Statue of Liberty, for example, contains 179,200 pounds), and in countless other applications. The new middle and upper classes created by Eastern industrialization have begun demanding the 'luxury goods' that many of us Americans take for granted. These classes will continue to grow, and the demand for commodities related goods will grow with them. Producers won't be able to keep up, not because they don't have the capacity to manufacture product, but because there are simply not enough mines to supply them the necessary raw material.
China and India's increasing need for raw materials alone could drive the bull for years and the study has yet to be done to show how increasing demand will race ahead of new production. Additionally, as countries like China and Japan which hold massive positions in U.S. dollars (in the trillions) begin to realize that their dollars are melting right out from beneath them, they will begin converting those dollars to more useful assets like precious/semi precious metals and the mines that produce them. This will happen as the East realizes that major inflation of the USD is inevitable, and will start the timer ticking toward what could be the biggest dollar downturn in decades.
Currently, the East is all dressed up for the ball, with nowhere to go. That is to say that they have the money, and nothing to spend it on. The political outcry over a Chinese attempt to use their massive wealth to buy large U.S. based raw materials companies makes the acquisition of such companies a virtual impossibility. Remember the hue and cry over the proposed tender offer for Union Oil of California or Noranda Mining in Canada? China will instead seek to buy producers in developing countries like those in Latin and South America or cut production deals with outfits like Codelco, Chile's state owned copper producer which also happens to be the largest in the world. They will come in with cash offers, and they have the dollars to buy whatever they want provided they do so behind the back, or out of the reach of U.S. politics. The lessons of the Dubai port deal will not go un-learned as China and India go about converting fiat into tangibles. No more buying the Rockefeller Center or Pebble Beach (a mistake the Japanese already made to their great chagrin). This time it's gold, gas, copper and zinc along with everything else a respectable first world country needs
Gas Prices Got You Down??
I won't even go into what a billion new car owners in India and China will do to oil prices over the coming years, and I won't talk about how oil producers are scrambling to find new deposits and projects. Suffice it to say, there is absolutely no way they will keep up with world demand. While we are on the subject---it is amazing to me that American's are surprised and upset by rising gas prices. They can only continue to be so---the environmental movement has seen to that. There has not been a new refinery built in the states since the 70's and God forbid that a caribou should have to hop over a pipeline in Alaska...For these reasons and more, oil prices will continue to rise until an alternate technology is developed. It is inevitable. Demand for oil can only rise as industrialization continues. Fairly static supply + rising demand = higher prices. No brainer.
America's inability to see past their pocketbooks is merely symptomatic of what French economist Fredric Bastiat referred to as "the fatal tendency of mankind" that is man's desire "to live and prosper at the expense of others...the insuppressible instinct to satisfy his desires with the least possible pain." I like to refer to this 'instinct' as good, old fashioned, jealousy compounded by greed. Most Americans see rising prices at the pump and immediately start yelling and screaming about big oil, or raving about war in the Middle East...take your pick. One thing they do not do, however, is jumping jacks over the fact that America is sitting on enough oil resources of it's own to satisfy a major portion of its consumption. I don't see anyone chaining themselves to the OSHA building (do they have a building??) demanding, in the name of world peace, that we be allowed to exploit our own resources. Think that's an exaggeration? Think again. People love to describe America's presence in the middle east as part of some master plan to control the world's oil supply, they've been doing it since well before 'the other Bush,' but you never hear anything about how the environmental movement has brought production and refining of national oil resources to a near standstill...And all over a 20x20 foot drilling platform. Wait....instead of the 'The War on Terror,' (which doesn't seem to have much pull with Americans these days) Bush could call it 'The War for the Preservation of the Environment.' I bet that would track much better with the so-called 'intellectual elite.' It should, by logical process, draw the support of those who think this is all just a big oil play, that is, if they were thinking, reasoning, people in the first place. But more than likely Joe America would just find someone else to blame or sue, and Ted Senator would have a new platform from which to placate his constituency all the while "pointing with pride" and "viewing with alarm".
Needless to say, oil prices aren't going anywhere but up until they go down and the "going down" part will have nothing to do with government and everything to do with market led alternatives, which are a long time in coming. A quick look at the import tariffs on ethanol will prove my point. Weeze gots to protect those corn producers in Iowa!!
When will it be over?
The good news is this is just the beginning. How will you know when it's over? A quick story...
In the late nineties I was living in a beautiful little nook in Tacoma Washington on the beach near Point Defiance. It was a wonderful spot, and I found that an afternoon stroll down the sand served as an excellent post-market close diversion. During my walks I would collect in my shoes a good amount of seaweed, sand, and other such souvenirs, and as a result I consistently employed the services of a professional carpet cleaner named Jack.
One day Jack informed me that he 'played the stock market,' and that he had won (he didn't say 'earned') a good deal of money investing in tech stocks, somewhere in the neighborhood of $150,000 dollars. He then flashed a knowing smile and proceeded to give me tips which I accepted gracefully with a "thank you, I will keep that in mind." Shortly after, I significantly reduced my exposure to these markets, for a variety of reasons. They had been over-bought for some time; Jack's tip just confirmed what I already knew.
How do you know it's 'too late?' When you can't get a hair cut without getting a tip on an exploration company. When you can't by a pair of shoes without the sales person talking about so and so's exciting new drilling results. When 'heap-leaching pit' comes up during a cab ride and not from you, that's when you know it's time to get out. But now is just the beginning...
Some weeks after the tech bubble burst I ran into Jack while buying a coffee at my favorite stop. He looked a little down in the mouth. When I asked him how he was he informed me that he had lost every penny in the market including some of what had been left to his wife upon the departure of her late father. "That's how these markets are," he said like a wise old sage, "sometimes your up, and sometimes you're broke."
"Buy" when there is fear, and "sell" when there is greed. That's how you make money in this business. I think I recall someone named Buffett saying something similar.
Some Investment considerations
Right now and for the last three trading days we have seen the precious metals and the stocks of same in a strong correction. This was not only anticipated but a sign as to how healthy these markets are at this point. Nothing goes straight up...ever. As of today, May 17th, the metals markets have rebounded and started to head higher again and just as in the past the leadership is coming from the big cap stocks.
One of the major risks in the mining sector today is the political---this is something we have learned over the years, and holds true today. Within the past two week, Evo Morales, the new President of Bolivia, began acting like the Marxist and, in true form, has initiated the process for "nationalization" of natural resources, starting with oil and gas. The nationalization will ultimately extend to mining and forestry as well. Morales is taking his lead from Hugo Chavez of Venezuela who helped finance his campaign for office. Chavez is throwing his oil money around like a drunken sailor and giving it to anyone who will oppose US interests. Unfortunately, this includes Canadian based mining companies---which have been such profitable part of our portfolio. Chavez is now helping Andres Obrador of the radical left wing party campaign for the presidency of Mexico. Three way races are often the vehicles which put wackos like Chavez and Obrador in power. Even Nestor Kirchner, the President of Argentina is starting to make life uncomfortable for mining companies seeking to do business in his country. But the good news is nobody really pays much attention to what is said or done in Buenos Aires, and the farther away they are from the capital the more this is the case. The mining districts are on the Eastern slope of the Andes and about as far away as you can get from the crazies in BA. This is a good thing, but not a sure thing (as Juan Peron proved years ago).
Paying close attention to where mining and natural resource exploration and production are being pursued is an integral part of "risk analysis" for this sector and can make or break an investment. For example, three months ago Anglo-American, one of the world's oldest and biggest mining companies announced it was moving its South American mining headquarters out of La Paz Bolivia and into Bogotá Columbia. This was a harbinger of epic proportion. Columbia, which for at least two decades has been a very rough neighborhood, is now coming back as a place to do business, thanks in large part to the diligent efforts of President Alvaro Uribe. It's a small comfort while Bolivia once again goes down the road to Marxist degradation and deeper poverty. This to say, Anglo-American saw this coming well before anybody else and acted accordingly. Having lived in Chile for seven years, and observed the attitudes of other Latin American peoples, it never ceases to amaze me how short their memory and how flagrant their disregard for political consequence. But, on second thought, I guess it is a worldwide malady...the U.S. being no exception.
Another major risk to natural resources stocks are pull backs of the type we are currently witnessing. Just as the stocks usually rise faster than the underlying commodities they are exploiting, they also fall faster and farther than the commodities themselves. I have been writing for months now about the similarities and the differences between this bull market and the one we had in the 60's and 70's (see above).
In this regard, another aspect of what must be remembered is how the 70's bull stalled between 1974 and 1976 before resuming its march to the highs of the 1979 and 1980 blow off. This halt in the advance caused many investors to lose heart and bail out of the sector before it really went crazy and the big money was made. Do Not let this happen to you this time around. Use these "retrenchments" or lulls in the action to reposition if you have already taken profits or to take positions if you missed the "first round".
That being said, a quick reminder is in order. The large cap stocks which you need to anchor your investments in this sector are Barrick Gold (ABX), Gold Fields (GFI), Gold Corp (GG) Glamis Gold (GLG) and Newmont Mining (NEM). All are traded on the NYSE and all have experienced significant pullbacks from their recent highs, some as much as twenty percent or more. A good way to know if these stocks are at their near term bottoms is to watch the price movements along with the volume. When the volume starts to dry up on the selling side it is a good sign indicating the bottom is close...buy when the stock starts to move up.
You may have noticed that Placer Dome (PD), one of our original calls, is no longer listed. It was bought by Barrick Gold, to our delight, and we made a ton on the deal. Before this bull exhausts himself we will see more of this type of consolidation of all types, large and small, producers and exploration companies. |
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